Interest rates

Despite the market turbulence of recent months, volatility has been limited during the past few years. Together with the flatness of both the US dollar and euro yield curves, this means that demand for correlation and volatility products has been strong among hedge funds and retail investors. Capitalising on this, BNP Paribas has executed more than EUR6 billion ($8.6 billion) of volatility notes and swaps since May 2006.

"We have seen a huge demand for volatility products since the final quarter of 2006," says Kara Lemont Sportelli, European head of interest rate and FX structuring at BNP Paribas in London. The French bank's innovations in volatility bonds include callable and min-max versions, which select index highs and lows to lock in the maximum realised volatility. An example of this is a US dollar volatility bond with a 'shout' option, which was issued in August by Dublin-based Depfa Bank. The bond has a five-year term and offers a 6.5% coupon on the first observation date, with the subsequent coupon based on the biggest movement in the 10-year US dollar swap rate. The shout option allows investors to fix the level of the final swap rate at their discretion during the investment period.

As correlation between interest rates and foreign exchange rates rises, BNP Paribas has developed dispersion products which allow investors to purchase volatility at low levels and sell correlation at high levels on foreign exchange rates and interest rates, including baskets of emerging markets currencies, baskets of global money market rates and points on the yield curve.

An example of the bank's dispersion products is a basket of US interest rates: three-month Libor and the two-year, five-year, 10-year and 30-year CMS rates. The product is also available in a five-year principal-protected version aimed at investors who think that the correlation between these rates will be low, so either a steepening or a flattening of the curve will result in a high coupon rate. If, as expected, the dollar rates are reduced, the curve will steepen and this will offer a high coupon.

So far this year, BNP Paribas has completed more than $250 million notional in interest rates and foreign exchange dispersion transactions. "The structures of the products we offer investors are both innovative and attractive. And we would consider launching further dispersion products in the future," says one head of structured products at a private bank in Paris.

In addition, BNP Paribas anticipated the changes in TFR savings account regulations in Italy in June this year by offering hedging and new investment products for companies and pension funds. But since the implementation of the new legislation, employees are allowed to invest their mandatory savings with a variety of providers, including the national social insurance companies and collective or individual pension funds.

For example, a swap provided by BNP Paribas against inflation for an Italian company that expects its employees to retire in the next five to 10 years offers the company the cumulative TFR rate at maturity while the company pays three-month Euribor. The firm can fully or partially cancel the swap earlier at no charge and still receive the cumulative TFR rate to that date, in order to match the early withdrawals which some employees may take in case of early retirement.

The bank has also offered a 10-year structured note for an Italian pension fund that wants to launch a product that outperforms the TFR saving rate while offering exposure to equity markets. The fund wants to deliver at least the TFR rate and ensure that returns are sufficient to meet the payment based on both the fixed and inflation component of the TFR rate. The 10-year note has a hybrid structure, which at maturity pays the maximum of the TFR rate cumulated over the investment term and a participation of 70% in the positive performance of the DJ Eurostoxx 50 index.

BNP Paribas has also been involved in the development of the property derivatives market, and in May this year sold Den norske Bank its first basket option linked to the Investment Property Databank indexes for the UK, Germany and France. The product pays the average return of the capital growth of these three indexes. "BNP Paribas is definitely the top property derivatives house in terms of pricing and innovation," says a London-based director of a real estate company.

The bank has also been active in developing contingent hedging products and has completed eight contingent interest rate hedges, six contingent foreign exchange forwards and its contingent inflation swap transaction, providing a hedge against a deal if it does not proceed.